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The impact of related party

transactions on the operational
performance of listed companies in
China
a b c
Yenpao Chen , Chien‐Hsun Chen & Weiju Chen
a
Department of Accounting , Soochow University , Taipei, Taiwan
b
Chung‐Hua Institution for Economic Research , Taipei, Taiwan
c
Deloitte & Touche , 12th Floor, Hung‐Tai Plaza, Min Sheng East
Road, Taipei, Taiwan
Published online: 26 Oct 2009.

To cite this article: Yenpao Chen , Chien‐Hsun Chen & Weiju Chen (2009) The impact of related
party transactions on the operational performance of listed companies in China, Journal of
Economic Policy Reform, 12:4, 285-297, DOI: 10.1080/17487870903314575

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 Journal of Economic Policy Reform
Vol. 12, No. 4, December 2009, 285–297

The impact of related party transactions on the operational performance

of listed companies in China
Yenpao Chena, Chien-Hsun Chenb* and Weiju Chenc
a
Department of Accounting, Soochow University, Taipei, Taiwan; bChung-Hua Institution for
Economic Research, Taipei, Taiwan; cDeloitte & Touche, 12th Floor, Hung-Tai Plaza, Min Sheng
East Road, Taipei, Taiwan
Journal
10.1080/17487870903314575
GPRE_A_431631.sgm
1748-7870
Original
Taylor
402009
12
chchen@mail.cier.edu.tw
Chien-HsunChen
000002009
and
&ofArticle
Francis
Economic
(print)/1748-7889
Francis Policy Reform
(online)
Downloaded by [Columbia University] at 04:37 11 December 2014

This study uses a comprehensive sample of 763 Chinese listed companies to explore the
relationship between the extent of related party transactions and operational
performance. The empirical results show that when the listed company is controlled by
a related party, the higher the level of related party transactions, the worse the
operational performance of the listed company; this is particularly true in the case of
related party transactions that involve sales, loans, guarantees and mortgages, or leases.
There is thus a clear need to improve the regulation of related party transactions and the
related disclosure requirements.
Keywords: related party transactions; corporate governance; ownership structure;

JEL Classifications: D21, G34, P31

1. Introduction
When the Chinese stock market was re-established, the Chinese government instituted a
system of market segmentation, the aim of which was to ensure that the market would be
able to support listings by a large number of companies; it was intended that the system
would also help to boost the share prices of listed companies, thereby enabling them to raise
more capital through the stock market. In the event, this system prevented the stock market
from achieving the stable, rapid growth that has characterized the Chinese economy as a
whole.1
On 29 April 2005, the China Securities Regulatory Commission (CSRC) promulgated
the Notice Relevant to Pilot Reform on the Segmented Shares Structure of Listed Compa-
nies as part of its efforts to promote improved corporate governance and stronger capital
markets. The notice was intended to reduce the disparity in earnings between tradable and
non-tradable shares, ensuring that all of the shareholders in a given company had a
common interest. By improving corporate governance, the CSRC aimed to reduce the deci-
sion-making cost accompanying major decisions; at the same time, it was expected that
reforming the equity structure of listed companies would facilitate the leveraging of the
stock markets for mergers and acquisitions (M&As) activity by high-growth companies,
thereby enhancing the overall quality of China’s listed companies and strengthening the
investing public’s confidence in the stock market.
During the 1990s, while stock market segmentation was in force, the Chinese govern-
ment actively promoted the stock listing of state-owned enterprises, in order to help these

*Corresponding author. Email: chchen@mail.cier.edu.tw

ISSN 1748-7870 print/ISSN 1748-7889 online

© 2009 Taylor & Francis
DOI: 10.1080/17487870903314575
http://www.informaworld.com
 286 Y. Chen et al.

companies overcome their financial difficulties. The quality of the assets held by state-
owned enterprises was highly variable; so many state-owned firms restructured themselves
and spun off their core assets in order to implement an initial public offering (IPO), while
leaving their non-core assets, debts, and surplus manpower in the residual state-owned
company. In this way, state-owned enterprises were able to improve their chances of a
successful stock market listing. The residual enterprises normally retained control of the
new, listed entity as the largest shareholder; however, having spun off their core assets, they
were often forced to rely on the listed entity for support. The listed entity could raise capital
through seasoned equity offerings (SEOs) and bank loans, and then re-lend the funds to its
parent company. Alternatively, the listed entity’s products might be sold to the parent
company at unreasonably low prices, or the listed entity might make payments to the parent
company for “consulting services” when in fact no services had been provided. In some
cases, the listed entity even provided collateral to help the parent company obtain bank
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loans. The cost of these related party transactions, which hurt the market value of the listed
entity, was borne by the smaller shareholders holding tradable shares.2
Following the promulgation of the Provisional Rules Concerning Accounting for Sales
of Assets between Affiliated Parties in 2002, basic guidelines were established to regulate
related party transactions, and restrictions were imposed on “unfair” transactions. This
significantly reduced the scope for listed companies to engage in earnings manipulation; as
a result, 2002 saw a pronounced decline in “extraordinary” related party transactions
between listed companies and their major shareholders involving the purchase or sale of
assets, entrustment, leasing, etc. (Lu and Fan 2003). However, as a result of the common
practice of state-owned enterprises restructuring themselves to secure stock market listing,
and because of the special equity structure of listed companies, many listed companies were
in fact unable to operate independently. As a result, related party transactions continued to
occur, and various measures were adopted to get round the government’s regulatory efforts.
On 15 February 2006, the Chinese government issued a new set of Accounting Standards
for Business Enterprises, which came into effect in 2007; these new regulations have
brought about some degree of improvement in the area of related party transactions and
disclosure.
Related party transactions are a widespread, long-standing form of business activity that
can have positive effects. Where related party transactions are implemented appropriately,
listed companies can make use of them to reduce transaction costs and achieve more effi-
cient asset utilization (Zhuo and Hu 2001). However, the motivation for engaging in related
party transactions is not always a laudable one. As a result of the widespread use of fraud-
ulent or unfair related party transactions for earnings management purposes or to siphon off
the assets of listed companies (and in doing so sacrificing the rights of small shareholders),
the positive aspects of related party transactions are often overlooked. The existing literature
on related party transactions involving listed companies in China – such as the studies by
Jian and Wong (2004) and Aharony et al. (2005) – has tended to ignore the relationship
between related party transactions involving the sale or supply of goods and operational
performance, and how this relationship varies depending on ownership structure. The aim
of this paper is therefore to explore the impact of the various types of related party transac-
tions on the operational performance of Chinese listed companies, including the way in
which varying intensities of related party transactions and different ownership structures
affect this relationship. The remainder of this paper proceeds as follows. Section 2 describes
a review of the literature and establishes the testing hypotheses. Section 3 explains the
research design. Section 4 discusses the empirical results, and the conclusions drawn from
this study are presented in Section 5.
 Journal of Economic Policy Reform 287

2. Review of the literature and development of hypotheses

Owing to the relatively strict requirements imposed by China’s stock exchanges with regard
to the criteria for maintaining listed company status, there is an incentive for listed compa-
nies to undertake related party transactions for the purpose of earnings management, so as
to achieve their desired levels of operational performance. China’s enterprise groups in
particular tend to make extensive use of related party transactions for earnings management,
in order to achieve the level of return on equity (ROE) required to avoid de-listing or to
issue new shares (Jian and Wong 2004). Listed companies employ different types of related
party transactions to achieve different operational performance indicator goals; for example,
related party sales may be used to achieve a given level of return on sales (ROS). Cheng and
Chen (2006) analyze the impact of related party transactions on the operational performance
of listed companies that engage in seven types of related party transactions with their
controlling parent company, comparing operational performance prior to stock market list-
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ing with operational performance after listing. Several studies have confirmed the use of
earnings management by large numbers of listed companies in order to achieve particular
levels of ROE (Chen and Yuan 2004, Liu and Lu 2007).
Besides the use of questionable earnings management methods to achieve operational
performance goals, related party transactions may also be used in a more acceptable manner
to reduce costs, as part of the vertical or horizontal integration within an enterprise group;
listed companies can employ this type of “strategic” related party transaction to achieve
performance goals by reducing transaction costs (Coase 1937, Khanna and Palepu 1997).
Regardless of whether a listed company uses related party transactions for earnings manage-
ment purposes or for strategic reasons, such transactions can help a company to boost its
operational performance.
Transactions involving the sales constitute a normal transaction for listed companies; the
revenue from such transactions will usually represent the company’s main source of oper-
ating revenue, and provides the basis for the calculation of many operational performance
indicators. Sales transaction data are thus often used to manipulate reported earnings perfor-
mance. Khanna and Yafeh (2005) point out that enterprise groups can use the “adjustment”
of sales volume and price data for intra-group transactions to manipulate their reported earn-
ings. Jian and Wong (2004) explore the use of related party transactions for earnings manage-
ment purposes among listed companies in China. They note that, as related party transactions
need only be disclosed as footnotes to a company’s financial statements, rather than being
reported directly on the income statements, and because of issues relating to processing costs
and general awareness, which make it difficult for investors to distinguish between regular
and irregular related party transactions, enterprise groups have considerable opportunity for
engaging in related party transactions that are undertaken for questionable purposes (Bloom-
field 2002). At the same time, related party transactions between companies that form part
of the same vertically or horizontally integrated enterprise group generally take the form of
the purchase or sale of materials or products; intra-group transactions of this type can help
the group as a whole to maximize profits and improve its operational performance because
of the lower transaction costs. This paper therefore establishes the following two hypotheses:
Hypothesis 1-1: The greater the extent of related party sale transactions undertaken by listed
Chinese companies, the better their operational performance.
Hypothesis 1-2: The greater the extent of related party purchase transactions undertaken by
listed Chinese companies, the better their operational performance.

Many listed companies in China are firms that were created by the spinning off of core
assets from state-owned enterprises. As a result, in most cases the controlling shares in
 288 Y. Chen et al.

listed companies are held by state-owned enterprises. Jian and Wong (2004) divided
Chinese listed companies into three broad categories according to their ownership structure
and the identity of the controlling shareholder: listed companies that are themselves state-
owned enterprises, listed companies where the controlling shareholder is a state-owned
enterprise, and other listed companies. The “others” category includes “traditional” compa-
nies, joint ventures, non-profit enterprises and various other types of company that are not
state-owned. In their study, Jian and Wong suggested that, where the largest shareholder is
a state-owned enterprise, it is likely to use related party transactions to boost the return on
assets (ROA). Related party transactions are one of the most common methods of transfer-
ring assets from one company to another. Listed companies in China generally maintain
close ties with the state-owned enterprise from which they were spun off, and the use of
related party transactions to transfer assets from the listed company to its state-owned parent
company is widespread. Aharony et al. (2005) indicate that the parent companies of Chinese
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listed companies often seek to manipulate the listed company’s surplus at the time of its IPO
and then, following the IPO, use related party transactions to transfer the listed company’s
resources to the parent company.
Many previous studies have noted that, where a controlling shareholder uses related
party transactions to siphon off a company’s resources, this has a negative impact on corpo-
rate value. Important past research in this area includes research on the expropriation of
minority shareholders (La Porta et al. 2000), the use of cross-shareholdings to strengthen
control over the target company and exploit other shareholders (Claessens and Fan 2002),
the existence of a negative correlation between abnormal return and the size of the control-
ling shareholder’s holding in a listed company (Cheung et al. 2006), and the pronounced
difference in performance between companies with highly concentrated ownership and
those with less concentrated ownership (Chen and Chien 2007). All of these studies show a
negative correlation between the level of control and corporate value. In this study,
therefore, the following hypothesis is formulated:

Hypothesis 2: Chinese listed companies that are controlled by another company will
display a higher level of related party transactions and worse operational
performance.

3. Research design and empirical model

The empirical model used in this study is based on Chen and Yuan (2004), Jian and Wong
(2004), Cheung et al. (2006, 2009) and Liu and Lu (2007). Each variable in the empirical
models is discussed in turn.

(1) Dependent variables (operational performance variables)

Return on assets (ROA) is an indicator used to measure the net return made by an enterprise
on the assets it has invested in. ROA is calculated by dividing net income by total assets;
ROA is used as an indicator of listed companies’ financial performance.
Tobin’s Q, which is based on market value rather than on corporate accounts, and thus
provides a more accurate picture of future operational status, is used to measure market
performance. Tobin’s Q is normally calculated by dividing the company’s market value by
the replacement value of its book equity (Morck et al. 1988, Barclay and Holderness 1989,
McConnell and Servaes 1990, Claessens et al. 1999). In China, owing to the unique equity
structure of Chinese listed companies, strict listing requirements and restrictions on the
 Journal of Economic Policy Reform 289

number of shares that can be issued have resulted in a situation where large quantities of
non-tradable shares exist (including state shares, state-owned legal person shares, domestic
legal person shares and civic legal person shares); therefore, Tobin’s Q in Equation 1 is
calculated using the method suggested in Jian and Wong (2004): share price (Adj _ PRCit)
is multiplied by the number of tradable shares in circulation (OutShareit), the book value of
the company’s debt (DEBT _ BVit) is deducted, and then the resulting figure is divided by
the book value of the company’s assets (A _ BVit).

Adj _ PRCit × OutShareit – DEBT _ BVit

Tobin' sQit = (1)
A _ BVit
(2) Independent variables (variables relating to related party transactions)
Sales transactions (RP_Sales) include both the sale of goods and the provision of services;
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purchase transactions (RP_Purchase) include both the purchase of goods and the receipt of
services. Asset transactions (RP_Asset) include the purchase and sale of all types of assets
other than commercial goods. Loan transactions (RP_Loan) are transactions undertaken to
obtain funds (including loans and equity funding, whether in cash or kind). Other
variables include guarantee and mortgage/pledge transactions (RP_Guarantee), asset lease
transactions (RP_Lease), and “other transactions” (RP_Other). In this study, the values of
individual types of related party transactions are divided by total assets to determine the
extent to which listed companies are engaged in particular types of related party
transactions.

(3) Control variables

In this study, company size (SIZE) is measured using the natural log of total assets
(Watts and Zimmerman 1978). To protect their own interests, creditors often include
clauses in loan agreements that require the borrower to maintain a given level of earning
ability or of net worth. By encouraging companies to try to maintain a reasonable level of
profitability, this has an impact on operational performance. To reflect this, the debt ratio
(DEBT) is also included as a control variable; the debt ratio is measured by dividing total
liabilities by total assets. Steady growth in sales can have a significant impact on opera-
tional performance, so the sales growth rate (SalesG) has been included as a control vari-
able. In addition, given that end-of-period stock prices can affect stock prices in the
following period, thereby affecting market value, the end-of-period share price at the end
of the last period (PRC) was also used as a control variable, and the adjusted closing
price was used.
To gain a clearer picture of the impact on operational performance of the various types
of related party transactions engaged in by Chinese listed companies, and of the impact on
operational performance of related party transactions engaged in by companies with differ-
ent control status, related party transactions are divided into three categories (sales,
purchases, and “others”) and seven categories (sales, purchases, loans, guarantees and mort-
gages/pledges, leasing, asset transactions, and “others”) respectively. The model A used to
explore the relationship between related party transactions and listed companies’ opera-
tional performance takes operational performance as the dependent variable, and uses ROA
(a financial performance indicator) and Tobin’s Q (a market performance indicator) as
proxy variables for operational performance. The empirical model A with three categories
is shown below. Equations 2 and 3 are used to verify Hypothesis 1-1 and Hypothesis 1-2,
respectively.
 290 Y. Chen et al.

ROAit = α + β1RP _ Salesit + β2 RP _ Purchaseit + β 3 RP _ Otherit

+ β 4 SIZEit + β5 DEBTit + β6 SalesGit + ε it (2 )

where ROAit is ROA of firm i in period t, RP _ Salesit is firm i’s related party sales transac-
tions as a percentage of total assets in period t, RP _ Purchaseit is firm i’s related party
purchase transactions as a percentage of total assets in period t, RP _ Otherit is firm i’s related
party other transactions as a percentage of total assets in period t, SIZEit is the size of firm
i in period t (measured using the natural log of total assets), DEBTit is the debt ratio of firm
i in period t, and SalesGit is the sales growth rate of firm i in period t.

TQit = α + β1RP _ Salesit + β2 RP _ Purchaseit + β 3 RP _ Otherit

+ β 4 SIZEit + β5 DEBTit + β6 SalesGit + β 7 ROAit + β8 PRCi,t –1 + ε it ( 3)
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where TQit is the Tobin’s Q value of firm i in period t, andPRCi,t − 1 is the price per share of
firm i’s stock at the end of period t-1 (i.e., the price per share at the beginning of period t).
Furthermore, ROA is incorporated to control for profitability of the firm.
The following model B with seven categories is also used to explore the relationship
between related party transactions and whether a Chinese listed company is the controlling
or controlled firm, and the impact on operational performance of different types of related
party transactions. Based on the aforementioned discussion, the empirical model B is shown
below. Equations 4 and 5 are used to verify Hypothesis 2.

ROAit = α + β1RP _ Salesit + β2 RP _ Purchaseit + β 3 RP _ Assetit + β 4 RP _ Loanit

+ β5 RP _ Guaranteeit + β6 RP _ Leaseit + β 7 RP _ Otherit + β8 SIZEit + β9 DEBTit
+ β10SalesGit + ε it ( 4)

TQit = α + β1RP _ Salesit + β2 RP _ Purchaseit + β 3 RP _ Assetit + β 4 RP _ Loanit

+ β5 RP _ Guaranteeit + β6 RP _ Leaseit + β 7 RP _ Otherit + β8 SIZEit + β9 DEBTit
+ β10SalesGit + β11ROAit + β12 PRCit –1 + ε it (5)

where RP _ Assetit is firm i’s related party asset transactions as a percentage of total assets
in period t, RP _ Loanit is firm i’s related party loan transactions as a percentage of total
assets in period t, RP _ Guaranteeit is firm i’s related party guarantee and mortgage trans-
actions as a percentage of total assets in period t, and RP _ Leaseit is firm i’s related party
lease transactions as a percentage of total assets in period t.
This paper focuses on companies listed on the Shanghai Stock Exchange and Shenzhen
Stock Exchange in China. The study covers the period 2002–2006. The following categories
of company were excluded from the sample: banks and insurance companies, companies
that have issued B-shares, companies that have been designated ST (Special Treatment) or
PT (Particular Transfer) firms,3 and companies the data for which did not cover all of the
variables used in this study. The sample comprised 763 Chinese listed companies (see Table
1). As the aim of this study was to examine the impact of related party transactions with
other companies on the operational performance of listed companies, related party transac-
tions between listed companies and individuals were excluded. The main data source was
the China Center for Economic Research (CCER) database, supplemented by data from the
Taiwan Economic Journal Data Bank.
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Table 1. Distribution of the sample by industry.

No. of Firms in Industry’s Share No. of Firms in Related Party
the Sample of All Firms in the the Industry Transactions
CSRC Industry Category Sample (%) Ratio (%)
Agriculture, forestry, animal husbandry and fishery 13 1.70 37 35.14
Mining and quarrying 7 0.92 22 31.82
Manufacturing 433 56.75 827 52.36
Electric power generation, gas and water supply 40 5.24 62 64.52
Construction 12 1.57 31 38.71
Transportation 34 4.46 63 53.97
Posts and telecommunications 37 4.85 82 45.12
Wholesaling and retailing 65 8.52 92 70.65
Real estate 39 5.11 58 67.24
Social services 29 3.80 41 70.73
Information and cultural industries 7 0.92 15 46.67
Other industries 47 6.16 77 61.04
Journal of Economic Policy Reform

Total 763 100.00 1407 54.23

Notes: The figures given for the number of firms in the sample exclude those firms eliminated (as described in Section 3) because they did not conform to the requirements
of the study.
CSRC industry category includes banking and insurance firms, which were excluded from the study.
The related party transactions ratio is calculated by dividing the number of firms in the sample that engage in related party transactions by the number of firms in the industry.
291
 292 Y. Chen et al.

4. Empirical results and analysis

The Variance Inflation Factor (VIF) was used to check each of the independent variables in
the empirical model for multicollinearity that might affect the empirical estimation. The VIF
values were all lower than the cut-off value of 10, indicating that the empirical results were
free from the problems of multicollinearity. In addition, the White-test was employed to
check for heteroskedasticity in each regression model. Because the regression results for the
empirical model using ordinary least squares (OLS) exhibit the problem of heteroskedastic-
ity, this study corrects this problem using White’s heteroskedasticity consistent standard
error estimator to re-estimate the regression results (White 1980). Only the robust results of
the empirical model are presented.
Table 2 presents the results of the impact of different categories of related party trans-
actions on operational performance. There is a significant positive relationship between the
level of purchases related party transactions (RP_Purchase) and ROA or Tobin’s Q. This
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means that the higher the level of related party purchase transactions undertaken by Chinese
listed companies, the better their financial and market performance. These results support
Hypothesis 1-2. The impact of other related party transactions (RP_Other) on Tobin’s Q is
found to be significantly negative, indicating that the higher the level of other related party
transactions, the worse the market performance.
In contrast, the empirical results presented in Table 2 show that there is no significant
correlation between the related party sales undertaken by Chinese listed companies and
either financial or market performance. The empirical results therefore do not support
Hypothesis 1-1.

Table 2. Empirical results of Equations 2 and 3 for various related party transactions.
ROA Tobin’s Q
Independent Variables Coefficient Coefficient
Constant −0.208 3.112
(−12.238)*** (22.043)***
RP_Sales −0.001 −0.013
(−0.900) (−1.250)
RP_Purchase 0.012 0.081
(4.289)*** (1.870)*
RP_Other 0.0003 −0.001
(−0.716) (−2.169)**
SIZE 0.013 −0.124
(15.852)*** (−18.649)***
DEBT −0.099 −1.387
(−19.728)*** (−42.109)***
SalesG 0.002 0.002
(1.513) (0.405)
ROA 1.184
(7.027)***
PRC 0.018
(7.739)***
Observations 3589 3589
R2 0.1729 0.5505
Notes: ***Indicates significance at the 1% level; **Indicates significance at the 5% level; *Indicates significance
at the 10% level. The t-statistics in parentheses are the White-adjusted t-statistics.
 Journal of Economic Policy Reform 293

Related party transactions are further divided into three groups according to the nature
of the listed company’s control status: “no control relationship”, “the listed company is the
controlling party”, and “the listed party is the controlled party”. As regards the relationship
between related party transactions where no control relationship exists and operational
performance (ROA or Tobin’s Q), as can be seen from the empirical results presented in
Table 3, when related party transactions are broken down into seven categories for the
purpose of analysis, both related party purchase transactions (RP_Purchase) and related
party lease transactions (RP_Lease) have a significantly positive impact on ROA, while
related party other transactions (RP_Other) have a significant negative effect. The results
tend to reinforce the findings in Table 2. Moreover, the empirical results in Table 4 reveal
that the coefficients of related party loan (RP_Loan) and lease (RP_Lease) transactions do
reveal a significant negative impact on Tobin’s Q.
As regards the relationship between related party transactions where the listed company
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is the controlling party and operational performance (ROA or Tobin’s Q), as shown in Table
3, related party guarantee and mortgage transactions/pledges (RP_Guarantee) have a signif-
icant and positive effect on ROA, while the empirical results in Table 4 illustrate that none
of the categories of related party transactions are significantly correlated with Tobin’s Q.
As regards the relationship between related party transactions where the listed company
is the controlled party and operational performance (ROA or Tobin’s Q), Table 3 shows that

Table 3. Empirical results of Equation 4 for various control relationships (ROA).

No Control Listed Company is Listed Company is
Relationship the Controlling Party the Controlled Party
Independent Variables Coefficient Coefficient Coefficient
Constant −0.215 −0.199 −0.231
(−12.095)*** (−5.312)*** (−10.458)***
RP_Sales 0.001 0.049 −0.006
(0.725) (0.895) (−1.859)*
RP_Purchase 0.008 −0.056 0.021
(2.956)*** (−0.559) (2.845)***
RP_Asset 0.002 −0.002 0.012
(0.067) (−0.047) (0.531)
RP_Loan 0.0003 0.165 −0.001
(3.967)*** (1.087) (−0.993)
RP_Guarantee 0.004 0.003 0.0001
(0.443) (5.104)*** (−0.380)
RP_Lease 0.003 −0.050 0.069
(2.495)** (−1.136) (0.662)
RP_Other −0.0001 2.030 −0.032
(−8.355)*** (0.072) (−1.570)
SIZE 0.014 0.013 0.014
(15.710)*** (7.072)*** (13.228)***
DEBT −0.103 −0.107 −0.100
(−18.952)*** (−10.609)*** (−16.773)***
SalesG 0.008 0.001 0.002
(2.880)*** (1.704)* (1.351)
Observations 3090 953 2547
R2 0.1981 0.1857 0.1741
Notes: ***Indicates significance at the 1% level; **Indicates significance at the 5% level; *Indicates significance
at the 10% level. The t-statistics in parentheses are the White-adjusted t-statistics.
 294 Y. Chen et al.

Table 4. Empirical results of Equation 5 for various control relationships (Tobin’s Q).
No Control Listed Company is Listed Company is
Relationship the Controlling Party the Controlled Party
Independent Variables Coefficient Coefficient Coefficient
Constant 3.022 2.639 3.099
(21.145)*** (11.367)*** (17.501)***
RP_Sales −0.011 0.078 −0.020
(−0.810) (0.140) (−1.132)
RP_Purchase 0.045 −1.161 0.236
(0.843) (−1.593) (1.994)**
RP_Asset 0.383 0.697 −0.015
(1.417) (1.035) (−0.110)
RP_Loan −0.001 0.543 −0.017
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(−2.054)** (1.013) (−3.571)***

RP_Guarantee −0.009 −0.003 −0.002
(−0.185) (−0.125) (−12.122)***
RP_Lease −0.046 −0.570 −2.094
(−4.814)*** (−1.440) (−3.234)***
RP_Other 0.000 −349.017 0.238
(−0.791) (−1.246) (1.824)*
SIZE −0.120 −0.099 −0.125
(−17.146)*** (−8.991)*** (−15.108)***
DEBT −1.377 −1.437 −1.357
(−38.156)*** (−22.230)*** (−35.972)***
SalesG 0.010 0.000 −0.001
(0.700) (0.098) (−0.531)
ROA 1.150 0.631 1.201
(6.142)*** (2.685)*** (5.976)***
PRC 0.016 0.015 0.018
(7.610)*** (5.950)*** (6.503)***
Observations 3090 953 2547
R2 0.5542 0.5162 0.5640
Notes: ***Indicates significance at the 1% level; **Indicates significance at the 5% level; *Indicates significance
at the 10% level. The t-statistics in parentheses are the White-adjusted t-statistics.

related party purchase transactions (RP_Purchase) exhibit a significant positive effect on

ROA, while the coefficient of sales transactions (RP_Sales) is significantly negative. As
shown in Table 4, loan, guarantee and mortgage/pledge (RP_Loan), and lease (RP_Lease)
transactions all have a significantly negative impact on Tobin’s Q; however, related party
purchase transactions (RP_Purchase) and other transactions (RP_Other) have a significant
and positive effect on Tobin’s Q. The results obtained with respect to sales, loan, guarantee
and mortgage and lease transactions thus support Hypothesis 2.
Based on the impact of the various types of related party transactions on operational
performance under different categories of control status, it appears that listed companies are
able to improve both their financial and market performance through related party purchase
transactions. However, where a listed company is engaged in related party sales with
another company that controls the listed company, this has a negative impact on the
economic resources of the listed company. A negative correlation is seen between loan,
guarantee and mortgage, and lease transactions and market performance, implying that the
 Journal of Economic Policy Reform 295

higher the level of these types of related party transactions, the worse the company’s perfor-
mance in the market. These results are generally consistent with prior research (e.g., Jian
and Wong 2004, Cheung et al. 2006).

5. Conclusions
The empirical results obtained in this study point to a number of salient findings and impli-
cations. The higher the level of related party purchase transactions engaged in by Chinese
listed companies, the better their financial and market performance. As regards the impact
on operational performance of related party transactions where the listed company is the
controlled party, the results showed a significant negative relationship between sales, loans,
guarantees and mortgages, and leases transactions and market performance. These results
indicate that the controlling shareholders of Chinese listed companies make regular use of
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related party transactions as a tool mainly for their own interests only. If the listed company
has been spun off from a state-owned enterprise, then there is a risk of the listed company
becoming a puppet to be manipulated by the state-owned parent company, with related party
transactions being used to transfer resources from the listed company to the parent
company, to the detriment of the listed company.
Chinese listed companies should focus on the use of related party transactions for posi-
tive purposes, such as: the internalization of market transactions to achieve economies of
scale, to optimize the allocation of internal resources, and to enhance overall enterprise
competitiveness; utilizing related party transactions to reduce the risk associated with exter-
nal market transactions; reducing transaction time and transaction costs; and reducing the
company’s tax burden, etc. If used in this way, related party transactions can help a company
to create value, rather than merely boosting the company’s reported earnings through earn-
ings management. Most investors are not in a position to tell whether related party transac-
tions are being undertaken for earnings management purposes, to siphon off the company’s
resources, or to trample over the rights of small shareholders and bond-holders.
The laws governing related party transactions in China are scattered among various
different statutes in the Criminal and Civil Codes, and the Securities Law, etc. In addition,
there are the ministerial regulations of the Ministry of Finance and the CSRC, the stock
exchanges’ own regulations, listed companies’ internal control systems, the accounting
systems applying to related party transactions, the tax system, disclosure requirements, and
the decision-making processes that are involved in related party transactions. This complex
mass of laws and regulations, nevertheless, has created a situation where there is a serious
lack of coordination and accountability, and where the overall effectiveness of the legal and
regulatory framework is limited. Little effort has been made to regulate the intermediaries
involved in related party transactions, and there are particularly serious deficiencies in the
disclosure system. All in all, there is considerable room for improvement. The most urgent
priority is to strengthen the related party transaction disclosure requirements, particularly
with respect to the disclosure of transfer pricing. China’s stock exchanges should be
encouraged to take their supervisory role more seriously, and accounting firms must start to
undertake more rigorous auditing of major related party transactions.

Notes
1. Market segmentation involved the establishment of two categories of listed company shares: trad-
able shares and non-tradable shares. On average, only around one third of a listed company’s
shares would be tradable shares, with the remaining two-thirds being non-tradable state shares or
 296 Y. Chen et al.

legal person shares. This system developed out of the special circumstances attending the trans-
formation of the Chinese economy. To begin the process of eliminating the distinction between
tradable and non-tradable shares, in 2005 China adopted a new policy whereby non-tradable
shares would be converted into restricted-trading shares, and eventually into freely tradable
shares; however, during the transitional period, all shares of this type were to be classed as
restricted-trading shares.
2. In China, the term guanlian fang jiaoyi is used for related party transactions.
3. If a listed company makes a loss for two years in a row, then the letters “ST” are affixed as a
prefix in front of the abbreviation of the company’s name used to identify its stock, and a daily
trading limit of 5% is imposed on the stock. If a listed company made a loss for three years in a
row, then the letters “PT” were affixed as a prefix. An (upward) daily trading limit of 5% was
imposed; there was no downward trading limit; the stock could be traded only on Fridays.
However, the PT system was abolished on 1 January 2002; de-listing has become immediate,
with no special transfer service provided.
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